Have you heard of STRIPs? They are a type of Treasury bond.
In my time I have recommended that my clients buy hundreds of millions of dollars – perhaps billions of dollars – of STRIPs.
However, let me tell you why it will be a bad idea for you.
Have you read the important notes? It’s a condition of visiting the blog.
A Nice Breakfast
One day this January I emerged from an elevator in a large bright atrium of a major institutional money manager. I was welcomed at the top floor by a smart-suited group that were all smiles and I was ushered into a large airy conference room and carefully positioned on one side of the large table so I had an excellent view of Boston harbor. The sun glinted off the water in the crisp winter air and made sun ripples on the polished shiny surface of the table. Along the walls were artworks with sharp vibrant colors; clearly positioned to give the impression that this was a modern forward-looking firm that was extremely profitable. I could tell they were ‘artworks’ and not pictures since they had small plaques underneath with the artists’ details. I was offered hot coffee from a shiny chrome pot with a china cup, a choice of fancy pastries and a wonderfully presented plate of freshly cut fruit. (Have you noticed how much better fruit tastes when it is chopped into bite sized amounts by someone else?) The group exchanged pleasantries and chatted a little while everyone settled with drinks and snacks. I was made to feel that my every comment and joke was the most interesting and funny quip they had heard for years.
I was here to talk about purchasing around $200M of STRIPs for my client, a fairly typical allocation for a medium sized pension fund.
The manager had assembled a show designed to impress, but from a money manager’s point of view STRIPs are perhaps the dullest instrument in the investment universe. They are very simple and their return basically only depends on how interest rates and inflation changes in the future. With stocks you can pontificate on sectors, valuations, earnings, etc. But there really isn’t much trading you can do when you’re managing STRIPs. It’s not a sexy investment, but they were clearly hoping for additional business down the line and were rolling out the red carpet for me.
In the investment world STRIPs have a very definite purpose. They are bought by insurers and pension funds to meet their long term commitments. If you know you have to make a payment in 30 years’ time and need to set aside money today in order to meet that future obligation, then STRIPs are the perfect instrument. They are bought in vast quantities by these institutions who prize their long term payment certainty and sensitivity to interest rates. If you buy a STRIP you know what you are going to get in the future, and if you are an insurer that needs to explain to the regulator how you are solvent then this is a good thing.
So I was pretty surprised to hear of individual investors buying 30 year STRIPs as they have some real risks
You may be familiar with Treasury bonds. If you want to lend to the US government so they can buy more schools, roads, cruise missiles etc then you can buy a Treasury bond. It’s actually pretty easy – you just create an account at Treasury Direct, or use your friendly local broker. You pay over a minimum of $100 and in return you receive regular interest payments every six months, called coupons, and at the end of the bond’s term you get a return of your principal. The coupon payments are (usually) fixed and are your ‘reward’ for loaning the Government your money.
Alternatively, you can buy into a Treasury fund from the usual suspects like Vanguard, Fidelity, Schwab etc. This might be a mutual fund or ETF.
STRIPs are Treasury bonds where the coupons have been removed and you are just left with the maturity payment. It’s sometimes called a ‘zero-coupon bond’, or ‘zero’.
Note that as a technical point, even though you receive no interest payments over the 30 years, the IRS requires that you recognize annual ‘interest’. These instruments are therefore more tax efficient in an IRA.
What's the Investment Pitch?
The pitch you will hear from 30-year STRIP proponents is the following.
Look at the size of that discount! That’s an enormous discount for buying a certain return over the future. You are absolutely guaranteed around 3% return currently because these things are safe as houses and backed by the full-faith and guarantee of the US Government making them safer than a savings account. But you wanna know the best thing? If rates fall then the price of these things will rocket and you could make a killing! So best case is you make an absolute killing, and the worst case is you make a certain return. It’s win-win!
Pretty compelling huh?
But before you rush out to Treasury Direct let’s unpick this.
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Two Parts to the Pitch
You will notice that the pitch is essentially composed of two parts and I will tackle each separately. Let’s highlight them in more detail.
PART 2 - If interest rates fall before maturity then you can sell it and make a fat profit
It’s a little bit like being given a winning lottery ticket for $1,000. However you have to wait 30 years to collect your winnings, but there is a chance over the intervening period that the lottery ticket could pay $10,000! Sounds good right? Well let’s see….
PART 1 - Certain Return
This is true.
As far as security goes these are the safest investments around. Default by the US Government on loan payments is not a scenario that is taken seriously by anyone outside the most extreme fringe. The Government can always print money, and anyway if the US Government is defaulting then I can tell you now that all investments are going to shit and you should have put your money in guns and tinned food.
Are 30 year STRIPs more secure than money market accounts or funds? There’s not a lot of difference so I would ignore that as noise. Money market accounts are backed by FDIC insurance and money market funds have some backing from the Treasury if the broker fails. Essentially we’re talking about the difference between Qdoba and Chipotle. The most burrito-oriented aficionados might see a difference, but nah.
Let’s now look at part 1 – the purported benefits of holding to maturity through three lenses:
- Inflation risk
- Return expectation
- Liquidity and opportunity cost
Yes, 30 year STRIPs can be bought at a nice looking discount. I know it feels a bit like buying a certain payout of a $1,000 lottery ticket for only $450. Yeah I know you have to wait for 30 years to collect your winnings, but that has to be a good deal – right?
These are some of the longest-term instruments you can buy. And 30 years is a long time during which your money can erode with inflation. It’s great that you will get $1,000 in three decades, but if inflation is high then it is entirely possible that you lose money on STRIPs in inflation adjusted (‘real’) terms.
Let’s look at that in more detail.
Currently (5/31/2019) STRIPs are yielding around 2.6% a year. That means that if you buy a STRIP for $450 you will be certain to see a return of 2.6% per year for 30 years. That’s a low return by any standards and should be enough to set off alarm bells. But let’s give this the benefit of the doubt and bring some rigor to the analysis.
If you hold a 30 year STRIP to maturity and future inflation is above 2.6% then you lose, and if inflation is below 2.6% then you make some real return on your money.
Historically inflation has been a mixed bag.
In the chart below I’ve shown the historical inflation rate for the last century and helpfully color-coded years with inflation in excess of 2.6% in red and below 2.6% in blue. You can see there have been plenty of post-war years with both.
In plain English – if future years have a lot of red then you have lost your shirt on the STRIP
But What About Future Inflation?
The above chart shows past inflation, but what about the future?
I could waffle on about my views but the fact is that I just don’t have a better insight into this issue than the banks, brokers or money managers that are buying and selling STRIPs.
Remember that money manager I visited in Boston? Behind the glitzy façade and fancy breakfasts they have a sweat-shop of economists, traders, actuaries etc setting their views on economic direction including inflation. These views help to shape the supply and demand price of STRIPs. The discount you receive has baked into it the collective views of the market on future inflation. If you think inflation will be less than what the market thinks, then maybe that’s a reason to buy, but I don’t believe you have a 30 year forecast of inflation that’s superior to anyone else.
Beware the person you meet that re-assures you that we are in a persistent low inflation environment. That may be the case over the next five years, or maybe ten years, but extrapolating for 30 years shows a lack of humility and a reckless excess of hubris. And would you tie up your money for 30 years based on that?
Hey! Chill Out!
Extraordinarily – in response to my inflation concerns I’ve had the response – hey AoF take a chill pill! If inflation goes up significantly I will just sell my STRIPs and buy into inflation protected bonds (“TIPS”).
Let me play back to you how this will turn out.
- Inflation rises unexpectedly, or there is the hint that inflation could rise unexpectedly. This could be due to any number of reasons; war with Iran, oil crisis, new government introduces massive infrastructure spending… there are plenty of valid scenarios.
- The market quickly reacts with STRIPs sellers slashing prices to make them more attractive to buyers in the face of impending inflation risks.
- Similarly the price of inflation protected bonds (TIPS) will rise dramatically as the demand for inflation protection in the new environment will attract a premium.
- You are then selling your STRIP at a low and buying TIPS at a high. Sad!
See the precipitous decline in November 2016? The market was rapidly assessing Trump’s policies and their impact on inflation. The market quickly decided that the Trump spending plans (remember the wall?) would push up inflation and so the price of STRIPs were slashed. This pricing correction was essentially instantaneous and based on nothing more than speculation about how Trump could impact the next 30 years of price inflation.
Do not tell me you are going to get ahead of that because some guy on facebook has posted a CNBC article.
Let’s move on from inflation risks to whether holding STRIPs to maturity is a good idea in terms of nominal return.
What About Return Expectations?
You might ask yourself whether the current discount on STRIPs is favorable. Currently a $1,000 face-value STRIP is around $450. But is that a good deal? What if it was $500, or $400? How should we think about this?
The way to think about this is to look at the current yield. The current discount on STRIPs implies a yield of around 2.6% a year. This is the same as saying that you can buy a $1,000 face value STRIP for $450, just put into yield terms.
The chart below puts that into historical context. Low yields mean high prices for STRIPs.
Over the last few decades interest rates have been falling, particularly at the long-end. You can see that historically yields on 30 year STRIPs are at an all-time low, and prices are at an all-time high. (By the way that weird gap resulted from when the Treasury temporarily suspended the issuance of 30 year debt.)
Does this make 30 year STRIPs a bad deal?
Not necessarily. Who knows what an appropriate yield is? A nominal return of 2.6% might be entirely appropriate for the next 30 years if inflation remains rock-bottom and rates continue to fall. But the fact is that you are buying 30 years STRIPs at all time high – that’s never a good feeling.
Liquidity and Opportunity Cost
Remember we are still assessing PART 1: If you hold the 30 year STRIP until maturity you will receive a certain return.
We have covered inflation risk and the nominal return outlook. Let’s now look at what you are giving up by holding your STRIP to maturity.
This section is just common sense and I don’t need any fancy charts (but I do have one).
If you are being asked to tie up your money for 30 years then you are forgoing all opportunities with those funds. That could be an opportunity to invest in a real estate deal, buy stocks, invest in your cousin’s business, pay down your mortgage, pay off your kid’s student loan etc.
Investors demand compensation for tying up their money and if I am going to tie up my money for three decades then I’m gonna need a lot of compensation!
For example that’s why your return expectation for private equity should be so much more than for publicly traded stocks. The difference is that with a private equity deal you don’t have access to your money and can’t easily sell.
I will contend that 30 years’ of 2.6% return is insufficient compensation for the illiquidity. But let’s look at comparing this return with cash – the most liquid investment.
Comparison with Cash Returns
I had a quick look on Bankrate.com and there were four banks offering savings accounts yielding 2.4% or more. (That’s not even looking at CDs where your money might be tied up for a year!) This is a cash account with instant access, and you are earning only 0.2% less than a 30 year STRIP!
So a 30 year STRIP is rewarding you for tying up your money with an additional 0.2% a year in return. You don’t need to be a Wall Street genius to see that is garbage!
You don’t need fancy analysis, long words and academic literature to assess investments and spot a bad deal. Just ask some sensible questions like “how does this return compare to cash?“.
To complete this section the following chart shows how the 30 year STRIP yield compares to the cash yield. You can see it’s historically low. In other words the compensation you are receiving relative to cash is low by historical standards.
Let's Wrap This Up!
So far I have written 3,000 words on PART 1: If you hold the 30 year STRIP until maturity you will receive a certain return.
I am going to break this post into two and the next post will tackle PART 2: If interest rates fall before maturity then you can sell it and make a fat profit.
I’ve analyzed Part 1 by looking at three areas.
- Inflation risk
- Return expectation
- Liquidity and opportunity cost
I’ve shown that historically inflation has exceeded the current 30 year yield and if this were to happen in the future then any profits would be wiped out. I observed that future inflation risk is not something you can simply mitigate by selling your STRIP if things go south.
I then looked at return expectations and I think it’s sufficient to observe that the yield on 30 year STRIPs is low any way you cut it; relative to cash, historically and in absolute terms.
Finally I showed you that you are receiving a pittance of compensation for lending your money to the Government for 30 years.
I can’t imagine giving PART 1 a more conclusive kicking. If you are being urged to buy 30 year STRIPs on the basis of holding them to maturity then you are being mis-sold – plain and simple.
However… we have yet to investigate PART 2.
Will there be any merit to holding STRIPs in the hope that rates fall and you can crystallize a profit? You will have to see the next part of this post to find out!
If you’ve done any finance or financial planning exams you might see STRIPs described as a suitable investment to match a future liability. For example you might have a child with future college expenses and so buying a STRIP provides you with a set-it-and-forget-it way of investing to meet that expense. That is valid reasoning…. for the short-term, or perhaps medium-term. But 30 years?!
The limitations I described above should dis-abuse you of that.
You might ask how I can be so duplicitous to recommend long maturity STRIPs for my clients and not for you? Pension funds and insurers derive a huge amount of accounting and hedging benefits from these instruments that out-weigh the disadvantages described above. Endowments, which have perhaps the closest goals to early-retirees’ goals, do not invest in 30 year STRIPs.
I’m not anti-bonds. Not by any means. That is not what I am saying. Buy bonds for risk management purposes. Just don’t buy 30 year STRIPs with the intention of holding them to maturity. It’s dumb.
Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my day job I advise corporate America on investment and retirement strategies. I am a qualified actuary, a registered investment adviser and have a PhD in mathematics and I reserve the right to include the occasional math post.